How to save while paying taxes

[jaydedman]

Here's our set up:
My wife (35) and I (40) are totally on board with this lifestyle. No kids. We live on about $24k now for all our basic expenses.

Being thrifty people, we paid for our home in cash and fixed it up. We recently bought a rental home for $150k on bank money, but plan to pay it off as quick as possible. It's an income generator at about $20k/year.

We work for ourselves being Scavengers: http://ebayscavengers.com So we have a comfortable life.

We can save about $50k after all expenses are paid. But what about taxes? I'm confused how we're supposed to save up the $625k to retire if we're paying taxes each year on this income. I don't mind paying taxes and am appreciative of living in a working society. But I don't see Mr Mustache talk about how he dealt with his income tax when he must have been making easily over $100k/year. He must have been in a high tax bracket, paying 20%+ of his income.

I know there are tax-free IRA's to sock income into, but then this doesnt really count towards the $625k that he needed to generate the 4% income each year, correct?

So are people actually saving $50k a year AFTER paying their income tax?

[ender]

... I don't understand what you are saying.

Generally people here talk about their post-tax savings rates. So a savings rate of 70% would mean, if you make $100k pretax and $65k post-tax, you are saving 70% of $65k.

You can also take advantage of a lot of tax deductions for retirement income. If you are married and max out two 401ks, two deductible IRAs, and a family HSA you will not pay income taxes, either federal or state, on a total of 2*(17.5+5.5) + 6.5 = $52,500 a year.

So if the MMM household was making $150k salary gross they would have only had taxable income of about $100k a year (depending on how they did pretax deductions).

[jaydedman]

Thanks for the answer. I've read MMM's blog posts and seen his numbers. I guess I'm confused how you get to the $625k nest egg that then produces 4% ($25K/yr) income that you retire on.

If I'm socking all my income into tax-free retirement accounts, then it's not actually going to produce income I can use till I'm in my 60's. So I assume the $625k needs to be in investments that produce 4% income now, correct? And all this money will be necessarily be taxable. If I have $50k gross per year in savings, it's going to take a while to hit that magic $625k because of the taxes I'll be paying.

Dos this make sense? I understand that everyone is talking about post-tax incomes, but isn't that really the rub? Social Security, Medicare, Fed, State taxes can really eat into $50k a year if I'm trying to save $625k in investments that aren't tax-free retirement accounts.

I apologize if I'm not approaching the question correctly, and maybe this info is better explained elsewhere on the forum. Maybe there's a tax strategy forum I'm missing.

[Zaga]

There are ways to get your money out penalty free.  Google a Roth Pipeline for one.  Also, remember that contributions to a Roth IRA can be withdrawn penalty free at any time.  Finally, your total portfolio in your example will need to be $625K, but it doesn't all have to be in taxable.  An example:

You have $400K in Traditional IRA's and Roth IRA's, and the rest is taxable.  The first few years you take your 4% from taxable, not 4% of the taxable, but 4% of the total portfolio.  While you do this, roll as much over from pre-tax IRA's to Roth IRA's as you can each year without going into too high of a tax bracket (only you can decide where that line is for you, probably 10-15%).  Then, when your taxable monies get low you'll have a good Roth pipeline going on that you can keep living on tax free or virtually so.

[Cassie]

There is also a way to take money out of traditional IRA's without paying a penalty if you are not 59 1/2.  If I am remembering it correctly you have to withdraw the same amount each year for 5 years and at that point must have withdrawn all the money.  If you make a mistake then you will get hit with the penalty.  You should look up the rules at the IRS website.

[dragoncar]

You save the money left over after paying taxes

[randymarsh]

I'm confused. You said you can save 50K per year and have tax-deferred accounts set up. If you put 50K in those accounts, you're not paying taxes (yet), except for FICA.

[golfer44]

Are you considering the compounding interest that investing that money will (hopefully) give you?

[jaydedman]

I appreciate all the responses. I think the "Roth Pipeline" is what I'm looking for. Put as much money into these retirement accounts tax free, and then unwind them over a period of time.

Seems the mantra is "save $625k and live off the 4% interest" is the mantra, but the details in getting there is where it gets interesting.

I'm sure someone on this forum has probably sketched out the scenario. I'll do some searching. Thanks again.

[Joel]

If you are married filing jointly, your standard deduction is $12,400 in year 2014, plus two exemptions at $3,950 each. That means your first $20,300 in income is tax-free. The next $18,150 is at a 10% rate. The next $55,650 is at a 15% rate.

$20,300 (tax free income) / 0.04 withdrawal rate = $507,500 nest egg required.

That means the first $507,500 you can set aside in tax-deferred accounts (401k, traditional IRA, etc.) will be tax free.

$18,150 (10% income) / 0.04 withdrawal rate = $453,750 additional nest egg (10% marginal).

The means the next $453,750 you can set aside in tax-deferred accounts will be taxed at 10%. That means you can set aside 960k in tax deferred accounts that are taxed at 0% or 10%. That is probably close to enough for most people.

$55,650 (15% income) / 0.04 withdrawal rate = $1,391,250 additional nest egg (15% marginal).

That means the next $1.4million you can set aside in tax-deferred accounts will be taxed at 15%. That allows for $2.3 million to be set aside in tax deferred accounts that are taxed at 0%, 10%, or 15%. That is more than enough money to retire on, and that is at a marginal tax rate that is lower than most people are paying during their working years.

That is why I contribute enough to my 401k and IRA in order to keep my marginal tax rate below 25% whenever possible.

 

[jaydedman]

This is awesome. Exactly what I was looking for. Thanks!